BoE releases stress test results and financial stability report

The Bank of England (BoE) released its financial stability report. Since the December 2022 Financial Stability Report, global interest rates have risen further, reflecting actual and expected increases in central bank policy rates in response to continued inflationary pressure. Returning inflation to target sustainably will support the Financial Policy Committee’s (FPC) objective of protecting and enhancing UK financial stability.

The sharp transition to significantly higher interest rates and greater market volatility over the past 18 months has, however, created stress in the financial system through a number of channels. The failure of three mid-sized US banks – and the failure of a global systemically important bank (G-SIB), Credit Suisse, due to long-running concerns about its risk management and profitability – caused a material rise in financial market risk premia and volatility earlier this year.

The impact on the UK banking system through lower bank equity prices and increases in funding costs was limited, and market risk sentiment has stabilized since then. Nonetheless, elements of the global banking system and financial markets remain vulnerable to stress from increased interest rates, and remain subject to significant uncertainty, reflecting risks to the outlook for growth and inflation, and from geopolitical tensions.

In the UK, given the prevalence of variable-rate and short-term fixed-rate mortgages and other loans, the impact of higher interest rates is relatively lower in the financial system than in the real economy, compared to some other jurisdictions.

The UK economy has so far been resilient to interest rate risk, though it will take time for the full impact of higher interest rates to come through. In the financial system, interest rate risks crystallised in Autumn 2022, with stress in liability-driven investment (LDI) funds requiring a temporary and targeted intervention by the BoE. The ability of those funds to absorb shocks has since been reinforced through the setting of new standards, and the rest of the UK financial system has so far been resilient to higher interest rates.

NBFIs: IRD and repo risks

In the report, the BoE warned that risks from higher interest rates can be amplified by non-bank financial institutions (NBFIs) Hedge funds and investment funds can have large and complex exposures to interest rate risk. While the risks from higher interest rates are borne ultimately by their end investors, the behavior of these funds in response to any losses caused by higher interest rates could exacerbate market moves. For example, hedge funds are often highly leveraged, and deleveraging behavior involving the sale of an asset, often as its price falls, can amplify market moves in stressed environments.

Furthermore, an increase in interest rates changes the attractiveness of certain investment strategies, potentially leading to investor redemptions from certain funds or restructuring of portfolios. For example, the recent continued outflows from open-ended property funds have been in part driven by higher rates. If redemptions take place rapidly, this might create liquidity pressures in certain markets, as was seen more broadly in the March 2020 ‘dash for cash’ episode. Rapid redemptions from funds operating in illiquid markets can lead to losses for asset holders. This, in turn, could lead to further deleveraging by asset holders and sharp increases in the demand for liquidity. It may also lead to funds selling their most liquid assets first, reducing the liquidity of portfolios. This could tighten financial conditions for UK households and businesses, and in the extreme can create solvency concerns for some financial institutions.

There was also mention of the use of interest rate derivatives and repo by financial institutions that can create leverage and liquidity risks needing to be managed appropriately. Derivatives are widely used – particularly by NBFIs – to enable financial system participants to manage their interest rate exposure in line with their investment strategies and risk appetite.

Derivatives can support the management of interest rate risk by financial institutions, and help to provide liquidity and support price discovery in markets. Central clearing and collateralisation of derivatives can also help to mitigate interconnectedness and counterparty credit risks. However, derivatives create leverage in the financial system – the management of which can amplify other risks in the economy and can present liquidity risks that need to be managed appropriately.

Firms in the insurance and pension fund sectors could be particularly sensitive to liquidity risk from their derivative investments, and LDI and pension funds have exposures via their gilt repo positions. These risks can materialize in the event of a sharp increase in interest rates, as these entities are unable to liquidate assets quickly enough to meet the large margin and collateral calls that arise.

Stress tests

The BoE also released the results of the 2022/23 annual cyclical scenario (ACS) stress test. Results indicated that the major UK banks would be resilient to a severe stress scenario that incorporated persistently higher advanced-economy inflation, increasing global interest rates, deep and simultaneous recessions in the UK and global economies with materially higher unemployment, and sharp falls in asset prices.

Reflecting resilience built up by banks in recent years, the results indicate the UK banking system would be able to withstand the severe macroeconomic scenario and has the capacity to support households and businesses throughout the stress.

The scenario is more severe than the 2007–08 global financial crisis (GFC). It is also substantially more severe than the current macroeconomic outlook, as it combines increasing interest rates with considerably higher inflation than recent peaks, along with deep and simultaneous recessions in the UK and global economies with materially higher unemployment.

The stress test scenario is not a forecast of macroeconomic and financial conditions in the UK or abroad. Rather, it is a coherent ‘tail-risk’ scenario designed to be severe and broad enough to assess the resilience of UK banks to a range of severe adverse shocks.

Banks start the stress test with improved asset quality since the last cyclical stress test performed in 2019, following increases in residential property prices, more conservative lending standards and changes in the composition of banks’ balance sheets. This dampens the negative effect of the macroeconomic shocks included in this scenario.

Banks also start the stress test with higher deposit balances than recent years, and net interest income (NII) increases as policy rates rise in response to higher inflation. This benefit is constrained by banks being required to assume that an increasing share of deposits are interest bearing, and that the interest paid increases by more than recent experience.
Reflecting a combination of these factors, the aggregate capital drawdown is smaller than in the 2019 ACS, despite the overall severity of the scenario being broadly similar.

The stress-test results indicate that in the scenario, all participating banks and building societies remain above their Common Equity Tier 1 (CET1) and Tier 1 leverage ratio hurdle rates on an IFRS 9 transitional basis in this test and no bank is required to strengthen its capital position as a result of the test.

For the first time, the test assessed the ring-fenced subgroups (RFBs) of selected participating banks on a standalone basis, where these differ materially from the group. All four participating RFBs also remain above their CET1 and Tier 1 leverage ratio hurdle rates in the test.

As in previous stress tests, banks’ resilience relies in part on their ability in a stress to cut dividend payments, employee variable remuneration, and coupon payments on Additional Tier 1 instruments, as well as other management actions taken in response to the stress. The Financial Policy Committee (FPC) judges it important for investors to be aware that banks would take such actions as necessary if such a stress were to materialize.

The results of the stress test support the FPC’s judgement that the UK banking system has the capacity to support households and businesses through a period of higher interest rates, even if economic and financial conditions were to be substantially worse than expected.

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